Izzy Englander built one of the most successful hedge funds around. But will his investors stick with him once they realize
that the next big hedge fund scandal may be brewing right under their noses?

It was rather unusual for Israel A. Englander, Wall Street legend, to summon traders away from their desks in the middle of a hectic day. But in the fall of 2003 he discreetly invited several of his top producers into a conference room at the bustling Fifth Avenue headquarters of his then-$4 billion hedge fund, Millennium Partners. For a few moments the traders forgot about options and swaps and shorts. The chat, according to one trader present, was vintage "Izzy," as the boss is widely known: clipped, to the point, laced with dry humor. He told them Millennium was doing just great, despite the fact that one of its traders had just pleaded guilty to criminal charges of securities fraud. Never mind that the SEC and the New York attorney general had launched an investigation. "Don't pay attention to what you see in the press," Izzy said. He assured them that the fund's legal troubles were under control. Then he lightheartedly told them to get back to making money or they all really would be out of work.

Englander was right about one thing: Millennium was doing great, at least in terms of its numbers. Indeed, it is one of the best-performing hedge funds around, averaging 17% a yearthat's after the nosebleed fees it chargessince it started in 1989. It returned 14% last year vs. the S&P 500's 11%; it even posted double-digit returns all through the recent bear market. Numbers like those have given the 57-year-old Englander an aura of infallibility, which has helped him attract a prestigious list of clients that reportedly include Duke University, the ultra-wealthy Canadian Belzberg family, and the Tisch family, which controls Loews Corp. (None would comment for this story.)

But the stellar returns also kept investors from asking too many questionsand those investors may be in for a surprise. FORTUNE has learned from people close to the case that Englander is in settlement talks with the SEC and New York attorney general Eliot Spitzer that could cost his firm upward of $100 million. These sources also say the settlement goes far beyond a lone trader behaving badly. This time the entire firm may be accused of securities fraud, and Englander himself could be charged with failure to supervise his brokers. "There was systematic, organized, pervasive wrongdoing on a huge scale at Millennium," claims one of the sources. Millennium spokesman Thomas Daly counters: "There was no fraud whatsoever."

The government's accusations have to do with the way Millennium traded mutual fund shares between 2000 and 2003. At one point a huge swath of the fund was allegedly dedicated to late-trading and market-timing mutual funds. (Late trading, which is illegal, entails buying fund shares after the market closes at a stale price, which can be valuable if there are late-breaking market developments. Market timing, which is legal but often forbidden by mutual fund companies, involves frequent trading of fund shares.) Sources close to the case say Millennium traders opened up thousands of mutual fund accounts to disguise what they were doing. Allegedly the firm even deployed a byzantine trading tactic that involved variable annuity accounts, employee road trips to New Jersey doctors for physicals, and lavish dinners at a horse-country resort. In all, the trading is said to have netted the firm hundreds of millions of dollars. Englander and his generals exhibited "a kind of giddy enthusiasm," says an investigator, almost as if "they were little kids who'd discovered a hidden stash of candy. They couldn't get enough of the strategy."

The hedge fund world is a hypercompetitive arena in which snagging strategies and talent from rivals is often considered business as usual; "paying the Street" for scraps of information or a sliver of a stock offering is de rigueur; and screwing over the next guy is sport. But Millennium may have gone even further than your typical type-A hedgie. Englander's distinctive operating philosophy fed the firm's record of outperformance, but it also attracted the scrutiny of regulators.

Millennium is not the first hedge fund to run into trouble in recent years. But the scandals that have generated so much attention of lateBayou Management, Wood River Partners, Canary Capitalhave been at much smaller firms. Millennium is a different breed: a Wal-Mart compared with those tiny 7-Elevens. It is, in fact, the biggest, most visible hedge fund to be embroiled in a scandal since the 1998 meltdown of Long-Term Capital Management. But LTCM's troubles began with a strategy that backfired, not with accusations of securities fraud. (And by the way, Millennium invested with Wood River; Canary was a Millennium investor.)

Since Millennium is such a big fish, a settlement could well be a major turning point in the battle to regulate hedge funds. (For more, see previous story.) "Hedge funds have to now accept much more institutional responsibility," says John Trammell, chief executive officer at Investor Select Advisors, which invests hundreds of millions with hedge funds. "It's like life: They're finally growing up. And some kids you thought were good might turn out to be pretty bad."

Izzy Englander is secretive, even by the standards of hedge fund potentates. He almost never talks to the press, shuns public appearances, and diligently tries to keep photographs of himself out of the public eye. (It almost goes without saying that he refused repeated interview requests.) He's fabulously richhis net worth is in the $1 billion range, and he made $205 million last year, making him the tenth-highest-paid hedge fund manager, according to Institutional Investor. His Manhattan home address is so fancy it just had a bestselling book written about it740 Park: The Story of the World's Richest Apartment Building, by Michael Gross. His neighbors include Ronald Lauder, Estée's son, and Blackstone Group's Steve Schwarzman.

Englander's aggressive style seems to have set in early. He didn't come from big moneyhe's described himself as "a yeshiva kid from Brooklyn"but his acquaintances describe him as if he's always been propelled by rocket fuel. After blasting through New York University, earning a finance degree in 1970, he enrolled in the school's MBA program. While at NYU, he worked at an influential Wall Street firm called Kaufmann Alsberg & Co. and quickly became intoxicated with the fast-paced, boisterous, and sometimes base world of trading. Englander once admitted to an associate that he was working so hard at his Wall Street job that he more or less "slept through the classes he managed to attend" at NYU. He quit the MBA program, never earning the degree.

In 1976, Englander became a floor broker at the American Stock Exchange, where his brother-in-law, famed investor Jack Nash, was a board member. At the Amex, Izzy forged some of his strongest and longest-lasting relationshipsseveral of his current partners at Millennium worked there. In 1984 he formed his own firm with another trader he met while at the Amex, John A. Mulheren. The firm, called Jamie Securities (Mulheren's and Englander's initials pushed together), invested in takeovers and restructurings. Mulheren was gregarious and generous to a fault. A man who wore eye-catching outfitsarmy fatigues topped off with hot-pink shirtshe was known for his giant personality and, at a hefty 6-foot-3, a complementary physique. People sometimes called Englander and Mulheren the "Odd Couple." Their partnership was golden for a whileJamie was a firm of choice for famed corporate raiders, including Boone Pickens and Wall Street bad boy Ivan Boesky. Then Boesky was convicted on insider-trading charges in 1987 and, in a plea for a lighter sentence, allegedly ratted out Mulheren, telling authorities he manipulated stocks at Boesky's request.

Mulheren was arrested in February 1988 after pulling out of the driveway of his Rumson, N.J., mansion with a loaded Galio assault rifle in the back of his Mercedes. At the time police contended he was heading toward Boesky's home to gun him down. (Charges were dropped after his lawyers argued that a stomach problem caused Mulheren to stop taking his lithium.) Mulheren was convicted in 1990 by a federal jury of securities fraud related to the Boesky charges. The conviction was later overturned; Mulheren died two years ago of a heart attack.

Englander, who was never implicated in the Mulheren schemes, went off on his own, launching Millennium Partners in 1989 with $35 million in capital. Millennium is an "odd duck compared to other hedge funds we've looked at," says a private detective who specializes in hedge fund reconnaissance. For one thing, it consists of a labyrinth of entities with different namesRiverview and Elm Grove, for instance, are apparently used for different types of trading. Another subsidiary, Millenco, is a broker-dealer. Then there are the fees. Hedge funds customarily charge a management fee of 1% or 2%; Englander's firm passes on most of the fund's expenses to investorsas much as 4% a year, which is almost unheard-of. (The fund also retains 20% of the upside in any given year, which is typical in the industry.)

And whereas just about all big, established hedge funds like to hire experienced analysts and traders to run money, Millennium, which has upward of 100 traders, has tended to be more of a sophisticated day-trading shop, say experts. "Englander takes traders off the street, gives them a pile of money, and says, 'Here's a chair and computergo trade,' " says someone familiar with the firm.

Many former employees of Millennium insist that there's nothing casual about the way Englander manages people once they're in the door. "Izzy's very serious when it comes to running his business," says onetime Millennium trader Robert Gelfond. "It's a no-nonsense place." His risk-management technique is straightforward: He fires any trader who loses a pre-determined amount of money. "You'd hear guys calling their wives, saying, 'Honey, I just got canned.' It wasn't pretty," says a former trader. Sometimes Izzy would throw traders out after a two-day stint. A former top trader at Millennium agrees: "He hates losses. He also has a major bullshit detector. If he hires someone who says they're doing a certain strategy and he finds out they're doing something else, he won't tolerate that." Says Peter Feinberg, a former Millennium trader who now heads institutional equity trading at Oppenheimer & Co.: "Izzy's an absolute straight shooter."

That's certainly the way Englander would like his investors to think of him: an upmarket guy who deploys an overwhelming array of ultra-sophisticated models that would simply baffle mere civilians. The firm has stated in its polished marketing materials that it devotes 55% of its capital to statistical arbitragethat is, an attempt to profit from pricing inefficiencies identified through high-end math. But one former trader says, "Stat arb is really a catchall phrase at the fund." To maintain an edge, Millennium began branching into what one insider calls an "almost anything-goes" mode. (Firm spokesman Daly adamantly denies that.) "They're the ultimate mercenaries," says a Goldman Sachs trader. "Total cowboys." The fund's traders aggressively pursue a wide a range of perfectly legal strategiesoptions, derivatives, shortingto find an advantage they can exploit. Millennium has lately amassed large positions in micro-caps; according to SEC filings, as of the beginning of the year one subsidiary owned a 5% stake or more in 11 American companies that are trading for under $5 a share; most trade around $2. (Daly says the firm doesn't "play in the micro-cap area.")

But that, according to people familiar with the government's investigation, is just the tip of the iceberg. Critics say that at Millennium there are just too many traders running different strategies. Daly counters that Millennium's traders are highly supervised, but at least one former trader at the firm begs to differ. "Izzy knows his guys sometimes use cowboy techniques to get an edge," this trader says. "He's not about to be knighted by the queen."

Englander has one other rule of thumb at Millennium: Just as poorly performing traders are shown the door, if a trader is performing well, he will get more money to manage. That principle may have led Millennium into its current skirmish with regulators.

Steven B. Markovitz, now 43, was by all accounts among Millennium's top-performing traders. And as time went by, he was given more and more money to handle. He started late-trading mutual funds in 2000, according to a criminal complaint that was later filed against him. Eventually supervising his own team at the firm, Markovitz began raking in the bucks, making around $40 million over two years, according to documents. "He had been a very conservative guy," says a trader who worked with him. "All of a sudden he was wearing these flashy clothes and taking private planes." Markovitz relied in part on a trio of brokers at Merrill Lynch to open accounts he used for trading. "Don't think we're not deviant motherfuckers and we don't want to explore [setting up mutual fund accounts] for you, all right?" one of the brokers said to Markovitz in an August 2003 phone conversation, according to a transcript included in a complaint filed by New Jersey's Bureau of Securities in March. "Don't think we're not trying to be creative." Moments later Markovitz responded, "There is no way you would, like, knock on the ... compliance door and say, 'Hey, I'm doing thisis it okay?' " The Merrill broker responded, "No fucking way!" (The Merrill brokers were later fired, and Merrill was fined $13.5 million by the New York Stock Exchange.)

When Markovitz pleaded guilty to charges of late-trading mutual funds two years ago, rumors circulated on Wall Street about whether Millennium, or Englander, would be implicated. The SEC and Spitzer's office announced investigations, and assets in the hedge fund dropped from $4 billion to $3 billion as investors pulled money out. But as time passed and no charges were filed, the buzz faded. Many assumed that the ordeal was probably overa conclusion encouraged, perhaps, by Izzy's reassurances to his own traders. Others thought a very quiet settlement would be reached. Millennium's performance numbers continued to be good, and new money swept in. The fund swelled to record size, now roughly $5 billion.

But Markovitz, presently ensconced in his multimillion-dollar Tribeca loft awaiting sentencing, was part of a much larger fund-trading scam, allege government investigators. (Markovitz did not respond to interview requests.) As much as a quarter of Millennium's capitalsome $1 billionwas devoted to mutual fund trading from 2001 through 2003, according to sources close to the investigation. Millennium employees were as busy as ants on a cupcake, allegedly opening up more than 1,000 accounts under different names through numerous subsidiaries at over 39 brokerage firms. The subsidiaries, which in turn opened up mutual fund accounts, had names like Wyatt Atwood & Co. and Castlemark. There was even one allegedly called Osaykanu LLC ("Oh say can you LL-see"), an apparent takeoff on the "Star-Spangled Banner." For the accounts, Millennium brass used their home addresses, relatives' addresses, and numerous Mailboxes Etc. box numbers. Englander allegedly used the address of his Greenwich, Conn., weekend house to open one or more accounts. The goal was allegedly to disguise what they were doing from the mutual fund firms. "The mutual funds would have booted them out if they were aware it was all Millennium," says someone familiar with the government's investigation.

The most provocative allegations revolve around Millennium's use of variable annuities, which are insurance products that act as tax-deferred investment vehicles. The firm apparently purchased variable annuities with premiums as high as $20 million, according to a complaint filed by New Jersey's attorney general. The variable annuities gave Millennium access to underlying subaccounts of mutual funds, in which they could trade largely undetected. To purchase the annuities, Izzy and as many as 25 Millennium employees allegedly trekked out to New Jersey, where they were examined by a doctor. Payment for the hassle: dinner on Izzy. Investigators say that post-physical, many Millennium employees headed directly to the Ryland Inn in the rolling hills of the Garden State's hunt country. One of New Jersey's priciest restaurants, it is described in one review as "the only restaurant in New Jersey ever to receive a four-star rating from the New York Times or to be awarded Relais & Chateaux-Relais Gourmand status."

Millennium's Daly says there is nothing unusual or illegal about using a variety of names and addresses for different subsidiaries and accounts. While he declined to comment on the specifics of doctor visits, he also says there's nothing illegal about buying variable annuities or getting physicals to comply with insurance rules. A person familiar with the government's investigation has a different point of view: "Why does a hedge fund need a variable annuity? That's just bullshit. Millennium is in trouble for creating entities, opening accounts, buying variable annuities for the sole purpose of deceiving mutual funds. That's securities fraud."

I know for a fact that Israel Englander and Millennium have not been in communication with regulators," says one investor who claims to speak with Englander fairly regularly. "There is just no story there." If only it were true. Behind-the-door settlement negotiations have indeed been ongoing, say several sources. Englander, who visited Spitzer's office as recently as late October, according to an insider, is willing to pay to settle the case and even admit certain indiscretions provided he isn't barred from the industry. Englander apparently isn't worried about the money. He's already set aside a kitty to help cover any company settlement: Around the time investors yanked that $1 billion out of the fund in 2003, Englander installed a "holdback provision," stipulating that 10% of an investor's redemptions would be retained to pay for any potential settlement. And what about the prospect of an investor revolt if charges come out? He's got protection there too: After the Markovitz scandal broke, he imposed a "gate" provision, which tightens the fund's control over the amount of capital an investor can withdraw within a specified period of time.

Of course, hardball measures like that don't make for happy investors. "Some investors are seething at the gate provision and champing at the bit to get out," says someone close to the case. It's certainly possible that some would stay, and highly probable that others would bolt, if not sue. Pensions, endowments, and charities might feel particular pressure to withdraw from a fund whose reputation had been impugned. Meanwhile, an insider says, "there's sheer panic at Millennium right now." It could be that the black box that Izzy built is starting to crack.